The high five: those market myths that just refuse to die
On closer inspection, some of the received wisdom on investment markets simply doesn’t stand up
All action at the NYSE: speculators looking for a quick buck bid up high-volatility stocks whereas the safe and steady stocks tend to get ignored. photograph: brendan mcdermid/reuters
Listen to the investment experts. Buy the best companies. High returns demand high risks. Such instructions might seem commonsensical and prudent, but the evidence underlying them is shakier than one might think. Here are five market myths that just refuse to die.
10 best days
There are many good reasons to advocate a “buy and hold” approach to investing, but the “10 best days” argument isn’t one of them.
Analysis of various international indices shows returns are halved if you missed out on the 10 best days in the stock market. Between 1928 and 2010, if you missed out on the top 1 per cent of all days in the stock market, you would actually have suffered large losses, despite being invested for 99 per cent of the time.
The idea is that it’s impossible to predict the handful of days on which these gains will occur; therefore, market timing is impossible.
This argument is profoundly misleading. Internationally, while returns do indeed fall by 51 per cent if one misses the 10 best days, they increase by 150 per cent if one misses the 10 worst days.
More crucially, of 15 major markets analysed by investment manager Mebane Faber, all enjoyed better returns than “buy and hold” if one missed both the 10 best and the 10 worst days. He advocates a trend-following approach whereby investors attempt to avoid declining markets. The best and worst days tend to cluster when the market is already declining, when indices are invariably more volatile.
There are arguments for and against the different strategies, but the least investors deserve is to have all the relevant stats presented to them, rather than advocates cherry-picking those that suits their argument.
Good companies are good stocks
A well-run company with a bright future might be a lousy investment, just as a company whose best days are long gone might well go on to enjoy great returns.
Take Microsoft, whose shares fell by 37 per cent between January 2000 and August 2013, when chief executive Steve Ballmer announced his imminent resignation. Ballmer and Microsoft made many well-publicised mistakes, losing the internet and mobile to Google and Apple, but it’s not as if the company suffered 13 years of stagnation. In fact, revenues more than tripled, from $23 billion (€16 billion) to $78 billion (€57.6 billion), while earnings grew by almost 9.5 per cent annually compared to 3.9 per cent for the S&P 500.
Microsoft was a good company but a bad stock in 2000 – trading on 75 times earnings, investor expectations were simply too rich.
It’s no isolated case. Investment manager John Dorfman has found stocks most favoured by analysts underperform the most despised stocks. Behavioural finance expert Meir Statman has also found that hated stocks outperform admired stocks, whose positive image pumps up their price and results in lower future returns.
One way of assessing popular companies is to look at trading volumes. A seminal study by Yale’s Roger Ibbotson, which examined 3,500 US stocks between 1972 and 2009, found that small, overlooked companies that attracted little trading activity returned 18 per cent annually, compared to just 6 per cent for very liquid small-caps. Among large-cap stocks, the most liquid returned 9 per cent annually compared to 12 per cent for the least liquid.
The worst results accrued to very liquid growth stocks – the high fliers that dominate media coverage – which returned just 3 per cent annually. In contrast, the least liquid value companies, the ugly ducklings of the markets, grew by 21 per cent annually.
There are many varieties of the investment expertise myth. On the one hand, you’ve got active fund managers, whose message is, “Leave it to us – we’ll deliver the goods.” Then you’ve got the peddlers of various trading courses, who promise to sell you their “secrets”. And then there are the DIY investors, who surround themselves with broker analysis, pore over the financial pages every day, and inflict all kinds of mind-numbing tasks upon themselves in order to keep up to date on the global economy and all things investment.
In reality, the vast majority of investment funds (including hedge funds) underperform the market, as do investment newsletter writers, investment clubs, analysts, DIY investors – the list goes on.
It’s possible to beat the market, but it’s difficult. Even supreme stock picker Warren Buffett advocates ordinary investors steer clear of all the investment agonising and simply invest in index funds that track the overall market. By doing so, “the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
Okay, news does move the market – just not nearly as much as is popularly believed.
In his book Irrational Exuberance, Nobel economist Robert Shiller examined the 50 largest market moves since the second World War and the accompanying media explanations. “Most of the so-called explanations do not correspond to any unusual news, and some of them could not possibly be considered serious news,” writes Shiller.
“The reasons given for large price movements included such relatively innocuous statements as ‘Eisenhower urges confidence in the economy’, ‘Further reaction to Truman victory over Dewey’, and ‘Replacement buying after earlier fall’.”
Much of the media’s daily coverage is just “snake oil”, says Shiller. “Then, the price level is firmly in the hands of investors with better sources of information.”
The problem isn’t simply that journalists are short on time and space. Firstly, markets anticipate news instead of reacting to it – that’s why investors buying on good news and selling on bad news aren’t long being parted from their money. Secondly, stocks rise because of supply and demand, which can be influenced by any number of unknown factors. This leaves the media scrambling for a news story to explain the price. In truth, the price is the news.
If daily market moves are not typically dictated by the news, why do they occur? Victor Niederhoffer, veteran trader and author of Practical Speculation, puts it well: “They tend to go down after there has been excessive optimism over the previous several days, and they tend to go up after there has been excessive pessimism”.
The notion that you must take more risk if you want higher returns seems commonsense, but it’s not always the case.
Low Risk Stocks Outperform Within All Observable Markets of the World is the title of a paper from the late Prof Robert Haugen.
Examining 33 countries (including Ireland) between 1990 and 2011, he found the least volatile stocks returned 8.7 per cent annually whereas the most volatile lost 8.8 per cent annually. Previous studies dating as far back as 1926 found the “same negative payoff to risk”, he added.
The same point is made by Pimco’s Charles Lahr, who says speculators looking for a quick buck bid up high-volatility stocks whereas the safe and steady gets ignored. Why? “Stock market participants in every country have this one thing in common,” says Lahr. “They’re all human.”